Meet John, a supermarket manager who is married with three school-age children and takes home a comfortably large paycheck. Sure he has some credit card debts and a couple of car loans, but he never misses a payment and assumes that getting a mortgage for a new home should be a piece of cake.
Then comes the bad news. After visiting several banks with a fat folder of financial documents, John is told he’s above the 43% Rule and can’t borrow the money.
What’s the 43% Rule?
It’s a ratio of debt-to-income, and a crucial standard for deciding who qualifies for a loan and who doesn’t.
In reviewing loan applications, lenders compute the ratio of a person’s debt relative to income. The standard for qualifying for a home loan is 43 percent, though it might vary a bit from lender to lender. If monthly debt payments exceed 43 percent of calculated income, the person is unlikely to qualify, even if he or she pays all their bills on time.
For other types of loans – debt consolidation loans, for example — a ratio needs to fall between 36 and 49 percent. Above that, qualifying for a conventional loan is unlikely.
The debt-to-income ratio surprises a lot of loan applicants who always thought of themselves as good money managers. Whether they want to buy a house, finance a car or consolidate debts, the ratio determines whether they’ll be able to find a lender.
What is a debt-to-income ratio?
Your debt-to-income ratio compares the amount of your debt (excluding your mortgage or rent payment) to your income. The ratio is best figured on a monthly basis. For example, if your monthly take-home pay is $2,000 and you pay $400 per month in debt payment for loans and credit cards, your debt-to-income ratio is 20 percent ($400 divided by $2,000 = .20).
Put another way, the ratio is a percent of your income that is pre-promised to debt payments. If your ratio is 40%, that means you have pre-promised 40% of your future income to pay debts.
How To Calculate DTI Ratio
So the trick for many would-be-borrowers is a budget before they go shopping for a loan. Lowering a debt-to-income ratio can be the difference between a dream fulfilled and rejection.
Calculating your debt-to-income ratio in easy 4 steps:
- Add up what you owe, including credit cards, rent or mortgage payments, car loans, student loans, etc.*
- Then calculate your income: wages, dividends and freelance income, for instance.**
- Now, convert each to a monthly figure. If your annual income is $60,000, the monthly total is $5,000. Do the same for debt. If your annual debt total is $30,000, the monthly total is $2,500.
- Now divide your debt by your income and multiply by 100 to arrive at a percentage representing your debt-to-income ratio. In this example, that would be 30,000 divided by 60,000 = .5 x 100 = 50%.
*Payments That Are Included In Monthly Debt Payments When Calculating DTI
- Monthly credit card payments (you can use the minimum payment when calculating your DTI ratio)
- Monthly mortgage payment
- Monthly car payment
- Monthly student loan payments
- Monthly personal loan payments
- Monthly debt consolidation loan payments
**Income Included In Your Monthly Income When Calculating DTI
- Income from wages, salary
- Income from tips, if applicable
- Income from self-employment (make sure it is verifiable via tax return)
- Income from alimony
- Income from child support
- Income from social security
- Income from a pension
- Disability income
- Income from investments such as rental properties, stock dividends (must be documented on tax returns)